The World Bank says India and China are poorer than previously thought. Though both are still among the world’s largest economies, the adjustment was not minor: the value of the two countries’ output dropped 40 percent. Yet despite this drastic adjustment, residents of either country will have just as much – or little – food, clothing and shelter as before.
The average person may well wonder just what the heck is going on. How can a country suddenly be 40 percent poorer than it was a day earlier?
The amounts of goods and services available to meet the needs of each country’s citizens did not change. Nor did their value in the local currencies – yuan or rupees. What did change was the exchange rate used to convert value-of-output and per-capita-income figures from yuan and rupees into dollars or euros.
When comparing nations, people often ask, “Well, what would that be in dollars?” and are frustrated when economists reply, “That depends.” But there is no single “right” method to convert values in one currency to equivalent values in another.
The most common approach uses prevailing exchange rates. If an Indian family earns 50,000 rupees per year and you need 39.3 rupees to buy one U.S. dollar, then their dollar income is $1,272.26.
Use this method if calculating what a trip to Europe will cost you. This is how international trade and financial transactions are made. But such prevailing exchange rates may be a poor basis for comparing “levels of living” between nations.
The problem is that identical products have very different prices in different countries even when converted to a common currency. Potatoes are cheaper in Peruvian village markets than in U.S. supermarkets. Haircuts cost much less in India than in Minnesota. A two-bedroom apartment in Tokyo costs many times as much as a comparable one in Eau Claire.
Simply converting GDP or per capita income figures at exchange rates listed in the newspaper without accounting for drastic differences in costs of similar products distorts the relative economic size of two countries and the income of citizens in each.
The solution is to calculate an exchange rate based on “purchasing power parity.” That is the exchange rate that would have to prevail to eliminate differences in costs of comparable goods and services.
Tabulating such PPP exchange rates is complicated. The World Bank checks prices of 1,000 different items in each country of the world. The latest survey is the first one India has participated in since 1985. For China, it is the first ever. Prior estimates of PPP exchange rates for China were much less methodical.
Using the new data, the dollar value of Chinese and Indian GDP dropped compared to the old ones. So did growth rates calculated for these countries over the past decade. The average American is even richer than before compared to Indians and Chinese, even if the daily life of people in any country, rich or poor, has not changed an iota.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.